AFG’s research has proven to be very effective at identifying winners and losers in the small cap space as evidenced by the performance of our Investment Grade metrics within the Russell 2000, our performance track record within our small cap model portfolio (Outperformed the Russell 2000 benchmark 8 out of 10 years) and several market calls regarding small cap stocks that have turned out well over the last several years.
The way that we often come to overall conclusions on the attractiveness of an entire sector or index is by aggregating individual company data for valuation or sales growth expectations for a group of companies through time and monitoring any trends that may stand out. While this process is not designed to come to any specific or refined number that will tell you that a sector or index is 12.5% undervalued as an example, it does however highlight specific trends that can alert investors to times of extreme over/undervaluation and identify entry/exit points. When sales growth expectations or valuation levels reach or approach bubble levels (+/- 1.5 StdDev) it signals that a segment of the market is presenting an opportunity that can be taken advantage of.
In the chart below you will see the market calls that we have made and the resulting performance of the Russell 2000 small cap index in relation to its Large-Cap brethren in the S&P 500. The red circles indicate a time on our blog when we identified the Russell 2000 as very overvalued and recommended reduced exposure to small caps. The green circle identified a point where valuation levels returned to normal levels and we ended our moratorium on small caps. As you can see the aggregations and analysis of small cap expectations and valuation have indeed identified solid entry and exit points that can help investors gain an advantage and avoid segments of the market that look extremely overvalued.
In November of last year, we concluded that small caps were once again approaching extremely overvalued levels based on the sales growth expectations priced in to the index. When we gather the Percent to Target (% valuation upside) of every company in the index and put in perspective relative to the historical Percent to Target of the index, the small cap universe currently looks quite a bit more overvalued than it did just 4 months ago. The aggregate data signals that the Russell 2000 index valuation level is outside of normal range and looks to be more overvalued than at any other point in the past 25 years.
While we were hesitant to recommend reducing exposure to small cap companies back in November 2016 due to so much uncertainty with proposed changes in corporate tax levels that could potentially boost many of these small caps, the valuation data is too strong to ignore. We once again recommend avoiding small cap stocks for the near-term future and find the Large Cap arena has a much more attractive outlook.
For the time being we will provide a list of 20 small cap stocks to avoid in your portfolios. These companies look extremely overvalued and currently earn an Investment Grade of “F”. If you own or are considering adding any of these names proceed with extreme caution as these firms have characteristics inherent in companies likely to underperform and our model has flagged them as potential torpedo stocks.
Russell 2000 – Stocks to Avoid